New Normal for the Oil VIX: High Levels of Fear

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Much like its stock market counterpart, the Oil VIX is showing a high level of uncertainty among investors as efforts intensify for stronger regulation of energy trading.

Though well off its historic highs, the Chicago Board Options Exchange Oil VIX, or volatility index, is reflecting a strong probability of substantial price fluctuation at a time of loud public clamor over rising energy prices.

But while proponents of a stronger government hand in regulating fuel prices are using oil volatility as a factor to bolster their case, the surge in the Oil VIX may well be just another metric in the "new normal" of rapid market swings.

"It’s brutal, but it's today’s reality," said Darin Newsom, energy analyst for DTN in Omaha, Neb. "It wreaks havoc, but it places more emphasis on risk management. It places more emphasis on looking at the structure of these markets rather than following whichever winds are blowing on a particular day."

An Oil VIX above 50 sounds alarming, just as a stock market VIX above 30 sounded alarming at one point. Yet stocks have managed to sustain a powerful rally over the past three months even as the so-called "fear index" has stayed above what had long been considered a benchmark reading for high volatility.

Both measures tend to rise when the underlying value they track falls. The VIX tracks the Standard & Poor's 500, while the Oil VIX tracks the United States Oil Fund ETF (AMEX: USO).

Consequently, the Oil VIX, a relatively recent addition to the CBOE, has been on a general downward trend since last December, when crude prices reached their most recent low and started rebounding.

The unpredictability of oil prices are at the center of a lively debate on whether trading ought to be more tightly regulated in order to counter the much-maligned speculators, who have been blamed for a summertime pop in gasoline prices that seems to be unsupported by demand fundamentals.

"This is not what the commodity markets were designed to do," oil trader Daniel Dicker told CNBC. "They were never designed to be investment vehicles. They were designed to be price discovery mechanisms, and we’ve lost that trend now."

The powerful influence of speculators—primarily institutional investors and other deep-pocketed traders with the power to move markets—has long been blamed for moves such as oil's jump to $147 last summer, and gasoline's leap to $4 a gallon.

With the drumbeat for change accelerating and the mood in the new administration much more amenable to regulation, the Commodity Futures Trading Commission said Tuesday it is considering measures to clamp down on oil trading.

Some traders say a crackdown on speculation will curb the oil trade, add to the current selloff in prices and essentially amount to overkill tactics for a problem that isn’t as big as it seems.

"I don’t think there are effective ways for government to get involved and fix this," Dicker said.

Newsom added that the markets are actually behaving the way they should, generating harsh pullbacks when prices get too high such as during last year’s oil boom, and bouncing up when prices get too low, as in December’s plunge below $34 a barrel.

But should the market be going to such extremes?

"Our notions of high, low, weak, strong have changed," he said. "What used to be incredibly high volatility is not any more. It’s just natural for a market to continue to grow and evolve like that."

As for popular market measures, investors may have to widen their "normal" parameters to higher highs and lower lows, with the hope that a true price emerges in between.

An Oil VIX above 50, for instance, doesn't merely represent the threat of a move higher, but rather indicates that traders are concerned about unpredictable moves either way. At the same time, the Oil VIX has been a somewhat less reliable predictor considering it is barely a year old and lacks the history to establish reliable benchmarks.

"There's risk in both directions," said one oil trader at the CBOE who asked not to be named. "I think what it is measuring is there's a growing amount of bimodal thinking on this."

Yet the Oil VIX is about half its level from December, also indicating that traders believe the worst of the volatility has passed and that trading is more likely now to find a range.

"As a consumer in an economy that I know isn't recovering too well, it's very frustrating to watch the price of gas go up at the pump," said Andrew Wilkinson, senior strategist at Interactive Brokers. "Maybe now the fundamental forces will reassert their pressure and bring crude prices down to where [they] should be."